IRS Form 1120-H is an often misunderstood form and the instructions can be confusing. All HOAs and condominium associations (whether residential or commercial) must file federal tax returns. In addition, most states require a state income tax return to be filed as well.Simple Navigation
- Form 1120-H Instructions
- IRS Form 1120-H Filing Requirements
- Form 1120-H Pitfalls
- Homeowners Association Tax Exempt?
- What is Exempt and Non-Exempt Income?
- What are some examples of exempt function income?
- What is non-exempt function income (taxable income)?
- What about expenses?
- Form 1120H vs Form 1120: Pros and Cons
- HOA Tax Return Tips and Tricks
- Form 1120-H and Tax Planning
But the interesting part is that HOAs actually have an option to file two different tax forms: (1) Form 1120-H; or (2) Form 1120. There are some important differences between the forms. But in most cases, the HOA will file IRS Form 1120-H.
Therefore, we’ve decided to break all this information down today to create the definitive guide of everything you need to know this year and the many years ahead. Not only will we cover the Section 528 requirements, we’re going to talk about Form 1120-H itself along with the instructions. We will also cover the risks of each form, exempt and non-exempt income, and some tips that’ll make the process easier.
After this, there are several other requirements including the fact that taxable income will include any income gained without being directly caused by the HOA itself. For example, membership dues are exempt but any income coming from facilities such as a hall, pool, or vending machine, are taxable.
If you need help with knowing what is and isn’t exempt from tax, we recommend writing down a long list for each as well as getting in touch with a specialized accountant who knows the Section 528 Requirements like the back of their hand.
Form 1120-H Instructions
For all HOAs, they can file two types of tax returns; Form 1120-H and Form 1120. As long as the HOA meets the requirements we have just discussed, Form 1120-H will be a possibility and this is the one specialized for HOAs alone. While Form 1120 can be found in other areas of accounting, Form 1120-H has been designed solely for this purpose. As we will see in just a moment, there are pros and cons to filing both but let’s talk a little about Form 1120-H first.
In terms of logistics, most HOAs will benefit from filing Form 1120-H if they have an opportunity and this is because the tax return form is just one page long, exempt function income will not be taxable, and the likelihood of being audited after filing is severely reduced. With Form 1120, this is always one of the biggest issues and it can lead to extra penalties and more taxable income being discovered.
IRS Form 1120-H is a relatively safe form to file. This form is specifically designated for “qualifying” homeowners’ associations. If the homeowners’ association qualifies to file Form 1120-H, only its non-exempt income is taxable. It will often provide a lower audit risk than the alternative Form 1120. Filing an HOA tax return is not without risk.
IRS Form 1120-H Filing Requirements
In order to file an 1120H, certain conditions must be met. The HOA must meet all of the following requirement:
- The HOA must be organized and operated for the purpose of providing either construction, acquisition, maintenance, management, or care of association property itself.
- At least 85% of the units are used by individuals for residential purposes.
- At least 60% of the gross income is derived from the membership fees, dues or assessments of owners in the association. This would also be called exempt function income.
- At least 90% of the expenditures for the tax year are used for the management, construction, acquisition, maintenance or care of the association property. This would encompass operating expenses as well as reserve expenses.
- No part of the HOA net earnings can benefit any shareholder, individual or owner.
If the above criteria is not met, the HOA cannot file IRS Form 1120H.
Under treasury regulation 1.528 the IRS divides income into either exempt function income or non-exempt function income. Exempt function income is specifically identified as not taxable, while non-exempt function income is taxable.
Form 1120-H Pitfalls
There is a one basic misconception among HOAs that file IRS form 1120-H. They often believe that fees charged to members for any purpose are automatically not taxable. This is not accurate. Many member fees are taxable. In order to determine whether a fee charged to a member is taxable or not, you have to look at the “nature and substance” of the fee itself.
Exempt function income relates to income that is attributable to membership dues, fees or assessments of owners “in their capacity as owner-members”. This is a key distinction. Because non-exempt income relates to other types of income and includes income received from members in the capacity as “customers of services.” Let’s take a closer look at what this really means.
Homeowners Association Tax Exempt?
In case you were unaware, Section 528 largely underwrites everything regarding homeowner’s associations and how they operate within the tax world. First and foremost, Section 528 describes how HOAs will be considered an organization when it comes to income tax and preparing an HOA tax return. After this, it then lays out some important requirements each HOA must meet if they’re to qualify for Form 1120H.
For example, all taxable income will be subject to 30% tax rates except for timeshare associations which will pay tax of 32%. In terms of taxable income, we have to look back to the basics and the definition of an HOA. According to Section 528, it says any organization designed to organize and manage association property is an official HOA.
For the first requirement, at least 60% of all income should come from membership dues, assessments, or any other fees that come from owners of the residential units. Considered the second main requirement from Section 528, at least 90% of all expenditure should go towards the general maintenance and upkeep of the residential properties or associated facilities.
What is Exempt and Non-Exempt Income?
So far, we’ve touched upon the topic of exempt and non-exempt income a few times but now we really want to dig into the logistics of it all. With personal tax returns, the process is easy because you can just list all your income and expenditure before then working out what you owe. With HOAs, the story is very different and the easiest way to explain it is that the IRS needs to work out which financial transactions (going either way) are a result of the HOA and which aren’t.
If we keep this in mind, all exempt income will be the earnings obtained as a direct result of offering the HOA properties so this includes membership dues and assessments. As we know, according to the Section 528 Requirements, these should make up at least 60% of all income in order to qualify for Form 1120-H. If this income doesn’t account for 60% of all your earnings, you might be forced into filing Form 1120 which has all sorts of implications as we saw above.
When assessing non-exempt income, this will be all revenue from non-association property. For example, this will include money earned from pool passes, car parking, laundry facilities, leasing a hall, and even something simple like a vending machine. Since all of these facilities and amenities aren’t part of the association directly, they are not exempt from tax. Additionally, this could also include capital gains and any interest you’ve accumulated over the past twelve months since the last filing.
As long as you remember that exempt income is all revenue from association property, this is all you need to know moving forward. From here, you can research individual items or ask your accountant if you’re unsure on anything.
What are some examples of exempt function income?
IRS Form 1120-H requires the allocation of income and expenses between “exempt-function income” and “non-exempt-function income.” Exempt-function income is the amount collected by the HOA from the dues paid by every homeowner. This income is not taxable. An example would be annual dues charged to all members for maintaining the HOA sidewalks.
What is non-exempt function income (taxable income)?
Non-exempt function income can be a little tricky. According to the instructions, if you generate income aside from assessments and fees in which the HOA members are acting as customers of the HOA. This also relates to income received for use of the HOA facility to the exclusion of the other unit owners.
Non-exempt-function income often comes from nonmembers, but it also includes income from members that are paid for the use of specific HOA amenities.
Let’s take a closer look at some examples of non-exempt function income:
- interest on bank accounts;
- dividend and capital gains;
- guest fees for pool usage;
- parking fees;
- laundry income;
- vending machine income;
- clubhouse rental (wedding, etc);
- cell tower lease income;
- income received from the rental of association property;
- golf course fees; and
- income from other for-profit activities (events, etc).
There are situations where it might be a little ambiguous. For example, an annual fee of $200 assessed against all members for the use of the recreation facility would be exempt function income and not be taxable income. However, an entry fee charged to members for use of the swimming pool would be taxable income. This is the case as the fee is assessed to members as customers rather than as owners.
Form 1120-H expenses
Like a for profit entity, an HOA can offset income with expenses incurred to generate that income. Expenses related to the production of the non-exempt income can be deducted. This would include cleaning, maintenance, state income taxes or advertising for the non-exempt income.
In addition, certain expenses may be allocated. This could include management fees, tax return fees, legal costs, insurance, utilities, repairs and cleaning. Any resulting net non-exempt function income is taxable, subject to a $100 standard deduction.
Form 1120H vs Form 1120: Pros and Cons
As soon as people see that Form 1120 offers less tax than 1120-H, they make up their mind on the spot and choose hastily. However, there are some important notes to consider. Yes, Form 1120 offers rates of 15% for the first $50,000 while Form 1120H is double this amount at 30%. Of course, this is something we cannot deny but this doesn’t mean that you should close this tab and download the Form 1120 document within ten seconds.
Not-for-Profit – First and foremost, the reason why most people think HOAs are free from the tax world and having to file tax returns is because they aren’t designed for profit. Therefore, you’ll need to keep this in mind when choosing between the two. If you don’t expect to pay any tax whatsoever, this tax rate should mean absolutely nothing and you should be looking at the associated risks instead.
Associated Risks – When deciding between the two forms, it’s critical you assess the pros and cons of each for YOUR situation. Sure, we’ve provided everything you need to do that but you still need to plug in your own numbers and assess the best option for you. Although the majority of people will prefer Form 1120-H, there are others who will file a Form 1120 this year because it suits their position perfectly.
As we know, one of the largest risks of filing Form 1120 is the chance of being audited. In our experience, the vast majority of audited HOAs in the past are ones that chose to file Form 1120 so this is another important consideration.
Can you afford to be audited at this point in time? Of course, we aren’t suggesting you’re hiding anything from the IRS as this would be a terrible idea but an audit could still bring up numerous issues from extra penalties to interest.
|One-page form; much easier to complete||Tax rates are higher at 30% rather than 15% (on the first $50,000 on Form 1120)|
|No tax on exempt income||Not all accountants specialize in this area which makes them hard to obtain|
|No alternative minimum tax (AMT)||No opportunity to file a net operating loss|
|Not every HOA will owe tax||Organizational costs cannot be written off|
|Less chance of being audited|
|Tax rates are much lower and can be half if you report profit of under $50,000||More likely to be audited|
|Much easier to find an accountant who will help||Resolution is required when planning|
|Form is more complex and tougher to complete|
|Not specialized for HOAs|
As you can see from the instructions, there are some important pros and cons to consider for both Form 1120 and Form 1120-H. Once you manage to find an accountant to help, make sure they have experience in this area of accounting because they can provide advice personalized for you which is more than the generic advice we can provide here today.
HOA Tax Return Tips and Tricks
With most of the important information done, we want to finish off with some fantastic tips that will help you get started with your HOA tax return in 2017!
Keep Up-to-Date – Throughout the year, keep all your invoices in order for expenses and income. For some reason, we tend to ignore the fact that tax season is always within twelve months. When the date suddenly rolls around, we face a mad panic to get everything done in time. Instead, create a filing system so everything is in place at the end of the tax year. Not only will this save you time, it’ll also save you money because it won’t be such a large job for your accountant.
Extension – If you left it too late and are going to now run out of time, don’t panic. Instead, get in contact with the IRS and request an extension. Unfortunately, it can be easy to mix-up the dates or simply put the letter in a drawer and forget about the whole thing. Luckily, the IRS isn’t full of monsters as well all seem to think and they actually want you to do well so an extension is an option they offer.
Tax Liability – Just because you have to file for tax every year, this doesn’t mean you actually owe tax and this is a huge misconception in the industry.
Think About Your HOA – Every year, you can choose between Form 1120 and Form 1120-H so don’t forget this. If you filed Form 1120 last year, this doesn’t mean you’re stuck on this side forever more.
Form 1120-H and Tax Planning
When filing an HOA tax return, one thing that is often overlooked is tax planning. Planning is very important for business owners and for individuals. Why shouldn’t it be important for homeowners associations as well?
Why is it so important to maximize your non-exempt expenses? Because the taxable income on an 1120-H tax return is high – 30% for HOAs using form 1120-H.
When filing form 1120-H, the association is not subject to tax on any net exempt function income. However, it is subject to tax on any net income from non-exempt activities.
What are non-exempt activities? Per the 1120-H instructions, they begin with interest income, dividends, and capital gains on association bank accounts and reserves. But they also include activities that are provided to both members and non-members in their capacity as “customers”. Let’s take a closer look at an example.
So let’s assume that an HOA collects monthly assessments from it’s members. It also has a clubhouse that is rented out on weekends, laundry facilities, and a cell tower.
The income received from members in the form of assessments is exempt income. Per the instructions, there is no tax assessed against this income. But what about the income from the clubhouse, laundry facility and cell tower? Any net profit on these activities is taxable at the high rate noted above.
But even though the income from the items noted above is taxable, the HOA gets to deduct expenses as well. The HOA is able to deduct any expenses that relate to the production of this income.
The HOA already gets to deduct $100 as a “standard” deduction. The HOA is allowed to deduct a portion of expenses it pays during the year. Some of the more common deductions are as follows:
- If the HOA pays any state tax for the given year it is allowed this deduction on line 12.
- A portion of the management fees paid by the HOA to the community manager are deducted as The deductible portion will be included on line 15. It will also be detailed in a statement to the return in support of line 15. The allowable portion is 10%.
- The tax return fee is a deductible fee also on line 15 to the return. The IRS allows this deduction in association with taxable income calculation. I have often seen CPAs and tax preparers include this amount as a component of exempt expenses.
How to navigate the 1120-H instructions
- Decide which form you need to file
You can file form 1120-H or form 11120. But forms come with pros and cons.
- Analyze state filing requirements
Each state is different. So make sure to take a look at the state instructions in order to determine filing requirements.
- Segregate exempt and non-exempt activities
The different activities should be broken out on the P&L for ease of tracking. Pay careful attention to the non-exempt activities and that may give rise to taxable income.
- Run a tax estimate using both forms
HOAs are unique in that they can select what form to file in a given year. Carefully consider which form is best in your situation.
When it comes to HOAs (homeowner’s associations), the whole process of being involved or being in charge of one can be rather rewarding and enjoyable. However, there’s one time of year everybody seems to despise and this is, of course, tax season. As we’ve discussed previously, filing an HOA tax return is unique for a number of reasons:
- Not all accountants will specialize in this area. We have discussed this issue here.
- Form 1120H is unique to HOAs.
- Not everybody is even aware that a tax return is necessary for an HOA.
- There are two different forms that can be filed; Form 1120 and Form 1120-H. Read the instructions carefully.
There are a few things you can do to make filing an HOA tax return easier. First, separate the member fees and assessments between exempt function and non-exempt income. This is rather easy by modifying the chart of accounts in the HOA accounting software. Second, make sure that tax planning is done early on with a qualified HOA CPA to ensure that any tax initiatives are implemented.
Over the past few years, Form 1120-H has gained a negative reputation but this is more to do with the lack of accountants who specialize in this area. When accountants manage to free some time during tax season, they aren’t likely to take on new clients in a new field and this leaves some people struggling. As long as you remember that you can file either form every year and you know the exempt and non-exempt income, you shouldn’t actually have a problem.
Most HOA tax returns are filed using IRS Form 1120H (per the instructions) even though the tax rate is higher. IRS Form 1120H is easier to prepare and most HOAs do not have taxable income, which makes the difference in tax rates irrelevant. Any HOA should try to minimize income taxes and reduce risk.